T.C. Mem o. 2 01 5- 96

UNITED STAT ES TAX COURT
VICTOR FARGO AND VIRGINIA KING, Pet it io ne rs v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt GIRARD DEVELOPMENT, L. P., GIRARD MANAGEMENT CORPORATION, TAX MATTERS PARTNER, Peti ti on er v . COMMI SSIONER OF INTERNAL REVENUE, Res po nd en t

Doc ke t No s. 2 89 70 -1 1, 1 66 -1 3. Fi le d M ay 26 , 20 15
.
W . AlanLaut an en , forpe ti ti on ers . Kath le enA. Tagn i an d J effr ey L. Hein ke l, fo r res po nd en t.

MEMORANDUM FINDINGS OF FACT AND OPINION GOEKE, Ju dg e: In the co ns ol id at edcas e atdo ck etNo. 2 89 70 -1 1,
res po nd en t d et erm in eda de fic ie nc y an d ape na lty

un de r se ct io n 6 66 2( a) wi th- 2 -

[* 2] res pe ctto th e joi ntin co m e ta x o f pe ti ti on ers Vict or Farg o a ndVirg in iaKin g (Far go an d Ki ng ) as fol lo ws: 1 Pen al ty

Year Defi ci en cy sec. 6 66 2( a) 20 02 $3 22 ,06 4 $6 4,0 52 Inth e co ns ol id at edcas e atdo ck etNo. 1 66 -1 3, re ga rd in g Gi rardDeve lo pm en t, L.P. (GDLP), an en ti ty sub ject t o p artne rs hi p p ro cedur es un de r se ct io n 6 22 6, 2
res po nd en t’s n ot ic e o f fi na l p artne rs hi p a dm in is tra ti ve ad jus tm en t (F PAA) de te rm in edth atth e p artne rs hi p h adreal iz edanord in ary in co m e g ai n fr om th e sa le of pro pe rty in 2 00 2 o f $7 ,47 4,6 45 rathe r th anth e rep orte d c ap it al ga in of $6 28 ,22 2. Afte r co nc es si on s b y

res po nd en t, th e is su es rem ai ni ng forde ci si on are:

3 (1 ) whe th er the sal e o f th e p ro pe rty in que st io n g en erat edcap it al ga in or or di na ry in co m e fo r Farg o a ndKin g. We ho ldth atth e sa le ge ne rat edord in ary in co m e; All do ll ar am ount s ar e ro un de d t o t he ne ares t d ol lar. 1 Unl es s o th erwi se in di cat ed , all sec ti on refe ren ces are t o t he Int ern al 2 Rev enue Co de ineffe ctforth e y ear i n i ss ue , andall Ru le refe ren ces are t o t he Tax Co urt Ru le s o f Prac ti ce an d P ro cedur e. Res po nd en t h as co nc ed edth atth e $ 36 0,0 00 de ve lo pe r fee pa idby G DLP is 3 in cl ud edinGDLP’ s b as is inth e p ro pe rty at is su e.- 3 -

[* 3] (2 ) whe th er GDLP’s rep orte d b as is inth e p ro pe rty at is su e m us t b e reduc ed
. W e h ol d t ha t the ba si s m

us t b e reduc edinpa rt; (3 ) whe th er p aym en ts to ta li ng $1 ,30 6,0 00 m ad e b y Ms . Kin g’s wh ol ly
own edS co rp or at io n, Gi rardMan ag em en t Co rp . (GMC), ar e o rd in ary an d
ne ces sa ry ex pe ns es . W e h ol d t ha t the y are n ot ; (4 ) whe th er GMC ’s paym en ts are d is tri bu ti on s t o M s. Ki ng . W e h ol d t ha t th ey are n ot ; (5 ) whe th er Farg o a ndKin g a re en ti tl edto th e fu ll am ou ntof ane t o pe rat in g lo ss carry fo rward . W e h ol d t ha t the y are n ot ; (6 ) whe th er Farg o a ndKin g a re en ti tl edto de du ctad di ti on al ho m e m ortg ag e in te res t. We ho ldth atth ey are n ot ; (7 ) whe th er Farg o a ndKin g a re en ti tl edto a de du ct io n fo r in ve st m en t in te res t. We ho ldth atth ey are n ot ; an d (8 ) whe th er Farg o a ndKin g a re l iabl e fo r anaccu racy-rela te d p en al ty und er se ct io n 6 66 2. We ho ldth atth ey are.- 4 -

[* 4] FINDINGS OF FACT A. Back gr ou nd So m e o f th e fac ts ha ve be enst ip ul at edan d a re s o fo un d. WhenFarg o a nd Kin g fi le d t he ir p et it io n, the ir r es id en ce was inCal ifo rn ia . GDLP’ s p rin ci pa l p la ce of bu si ne ss was a ls o i n C al ifo rn iawhen it s p et it io n was fil ed
. Farg o a ndKin g wer e en ga ge d i n t he real est at e b us in es s dur in g a ll rel ev an t pe rio ds . Ms. Ki ng is a li cen se d re al est at e b ro ke r inCal ifo rn ia . The co up le
co nduc te d t he ir b us in es s thr ou gh a nu m be r of en ti ti es , in cl ud in g GM C; Farg o In du strie s C or

p. (F IC), a C co rp or at io n wh ol ly owne d b y Mr. Far go ; Ki ng Real Est at e, In c. (KRE), a C co rp or at io n wh ol ly owne d b y Ms . Kin g; GirardPro pe rty Co rp . (GPC), a C c or

po rat io n wh ol ly owne d b y Ms . Kin g; an d GDLP, a TEFRA pa rtn ers hi p o f whi chMr. Far go an d M s. Ki ng are d ire ct ly or in di rect ly the
m ajor ity pa rtn ers an d GM C is th e ta x m at te rs pa rtn er. Num ero us co m m erci al real
es ta te de ve lo pm en ts were co nduc te d t hr ou gh th ei r rel at eden ti ti es . B. Acqu is it io n, Dev el op m en t, an d S al e o f th e La Jo ll a Pro pe rty The ba ck gr ou ndof t he real est at e tr an sa ct io n i n i ss ue be gi ns inDecem be r 19 88 . FIC acqui reda le as eh ol d fr om La Jo ll a Me di cal Bu il di ng Co rp ., an un rel at eden ti ty, to lea se a 2.2 -acr e p arce l o f rea l es ta te (La Jo ll a p ro pe rty) in cl ud in g abu il di ng an d s it e d ev el op m en t p lans . The La J ol lapro pe rty’ s ad dr es s- 5 -

[* 5] was 72 55 GirardAven ue , La Jo ll a, Cal ifo rn ia . The o wne r of th e La Jo ll a pr op erty was La J ol laCo un try Club. FIC acqui redth e le as eh ol d i n t he La Jo ll a pr op erty with t he pl an s t o d ev el op a 72 -uni t ap art m en t co m pl ex an d re ta il sp ace. The lea se ho ldwas p ur ch as edfor$2 ,70 0,0 00 , pai d i n i ns ta ll m en ts en di ng in19 90
. The lea se ag reem en t b etweenFIC an d t he La Jo ll a Co un try Club i ni ti al ly ran th ro ug h 2 00 8 b utwas s ub se qu en tl y ex te nd edto run th ro ug h 2 04 2 fo r ad di ti on al
co ns id erat io n o f $9 00 ,00 0. Th e le as e was ex te nd edto all ow Fa rg o a ndKin g m or e ti m e to de ve lo p the La Jo ll a p ro pe rty. Whe n F IC ac qu ire d the lea se ho ldinth e La Jo ll a p ro pe rty, it al so acqui red th e im pr ov em en ts th atha d b eende ve lo pe d b y La Jo ll a Me di cal Bu il di ng Co rp ., in cl ud in g aten an t-o ccupi edm ed ic al bu il di ng an d c ert ai n p lans , dra win gs , rep orts , su rv ey s, an d p erm it s. The lea se ag reem en t b etweenth e La Jo ll a Co un try Club a ndLa Jo ll a Med ic al Bu il di ng Co rp . was due to ex pi re o n Au gu st31 , 20 08 . In o rd er t o e xt en d th e te rm of t he lea se pa stAug us t 3 1, 2 00 8, La J ol laMed ic al Bu il di ng Co rp . hadto
m eetcert ai n c on di ti on s p rece de nt , in cl ud in g re de ve lo pi ng th e La Jo ll a p ro pe rty acco rd in g t o t he term s o f th e le as e ag reem en t. FIC acqui redLa Jo ll a Me di cal Bu il di ng Co rp .’ s l eas e wit h t he same con st rai nt s.- 6 -

[* 6] In19 91 FIC tran sf

erre d the lea se ho ldinth e La Jo ll a p ro pe rty to GDLP fo r a cap it al co nt rib ut io n c red itles s tha n F IC’s b as is inth e p ro pe rty. At the ti m e o f it s fo rm at io n a ndth e co nt rib ut io n o f th e le as eh ol d, GDLP en te redin to va rio us ag reem en ts with re la te d p art ie s fo r th e d ev el op m en t an d m an ag em en t o f th e La Jo ll a p ro pe rty. T ho se ag reem en ts pro vi de d fo r th e p aym en t o f va rio us fees for
su chservi ces . After GDLP ac qu ire d t he lea se ho ld , sev eral hurd le s t o t he de ve lo pm en t o f th e La Jo ll a p ro pe rty aros e. Inth e ear ly 199 0s th e rea l es ta te
m ark etinLa Jo ll a d ecl in eddra m at ic al ly. As a re su lt , dev el op m en t o f th e La Jo ll a pr op erty was s us pe nd ed . Non ethe le ss , Mr. Far go so ug htfin an ci ng to de ve lo p i t. Inan ot he r at te m

ptto ob ta in fin an ci ng , GDLP purch as edth e La Jo ll a p ro pe rty fro m th e La Jo ll a Co un try Club i n 1 99 7 i n fe e si m pl e fo r $1 ,75 0,0 00
. In19 93 Norb y , Inc . (Norb y ), anun rel at eden ti ty w ith wh ic h M r. Farg o a nd FIC h adpre vi ou sl y

work ed , fil eda la wsu itag ai ns t M r. Farg o a ndFIC b ecau se Mr. Farg o a ndFIC h adde fau lt edon a $1 0 m il li on lo anforanun rel at edde ve lo pm en t pr ojec t. The pa rti es ne go ti at edto pa rti al ly reso lv e th e Norby lit ig at io n wi th a pa rtn ers hi p i nt eres t i n GDLP, an d No rb y acqui reda pa rtn ers hi p i nt eres t i n GDLP in Octo be r 19 91 . The n eg ot ia ti on s re su lt edinanam en de d p artne rs hi p a gr eem en t, anam en de d m ark et in g a ndbro ke rag e ag reem en t, an d apro pe rty m an ag em en t ag reem en t.- 7 -

[* 7] Thro ug h 2 00 1 t he La Jo ll a p ro pe rty was d ev el op edforres id en ti al us e. The
ex te ntof p hysic al im

pr ov em en ts was l im it edto m in orrep ai rs . Thes e m in orrep ai r co st s wer e cap it al iz edan d a m orti zedov er the co ur se of t he ho ld in g p eri od . At th e en d o f 20 01 th e b al an ce o f th e le as eh ol d i m pr ov em en ts was re po rte d t o b e $7 3,4 06 .55 . Alth ou gh Farg o a ndKin g d idno t m ak e subs tant ia l al te rat io ns to th e La Jo ll a p ro pe rty, GD LP cap it al iz edsubs tant ia l am ount s fo r co ns tru ct io n i n pr og res s. Fro m

19 91 th ro ug h 2 00 1 GDLP capi ta li zed$1 ,82 8,9 82 of c on st ru ct io n in pro gr es s. Inth e y ears 19 99 , 20 00 , and20 01 GDLP in cu rredco st s fo r co ns tru ct io n o f $2 33 ,00 0, $ 21 6,3 37 , and$9 99 ,58 5, re sp ect iv el y . Thes e co st s pr im ari ly com

pr is edarch it ectur e, en gi ne eri ng , app rai sa l, p erm it s, an d l ic en si ng fees
. Befo re GDLP pu rch as edth e le as eh ol d, La J ol laMed ic al Co rp . us edth e bu il di ng as r en ta l s pa ce fo r m ed ic al off ic es . After t he 19 89 acqui si ti on of t he le as eh ol d, re nt al in co m e was ge ne rat edfro m ten an ts oc cupyin g t he m ed ic al of fic es . From 19 89 un ti l the ti m e th e p ro pe rty was s ol d, the ren ta l i nc om e was th e on ly inc om e g en erat edfro m th e La Jo ll a p ro pe rty. In ad di ti on to co ll ect in g re nt , Mr. Farg o’s re nt al co m

pa ni es us edth e b ui ld in g fo r th ei r bu si ne ss op erat io ns . FIC, GDLP, andot he r en ti ti es own edby Fargo an d Ki ng us edth e b ui ld in g a s o ffi ce sp ace f oracco un ti ng , bo okke ep in g, an d o th er b us in es s p ur po se s.- 8 -

[* 8] Afte r 19 89 th e La Jo ll a p ro pe rty was m ai nt ai ne d a s a b us in es s l oc at io n a nd
ren ta l p ro pe rty. In 19 93 GDLP ent eredin to anag reem en t wi th KRE, a real est at e m an ag em en t co m

pa ny owne d b y

Ms . Kin g. Th e ag reem en t p ro vi de d t ha t KRE
wou ldm an ag e, op erat e, m ai nt ai n, an d l eas e th e La Jo ll a p ro pe rty. G DLP pai d KRE $3 ,00 0 am on thforit s s erv ic es . No s ub st an ti al effo rts were m ad e to so li ci t p ot en ti al bu y ers forth e La Jo ll a pr op erty be fo re 2 00 1. GDLP ne ve r li st edth e La Jo ll a p ro pe rty for s al e an d n ev er m ark et editto real est at e d ev el op ers . The o nl y effo rt t o s el l the La Jo ll a p ro pe rty was m ad e in 19 93 , when GDLP ent eredin to a m ark et in g a ndbro ke rag e ag reem en t with GPC , a real est at e b ro ke rag e co m pany owne d b y

Ms . Kin g. No ne th el es s, GPC n ev er u nd ert oo k s ub st an ti al effo rts to sel l the pro pe rty. In20 01 Cen te x Ho m es , an u nr el at eden ti ty, m ad e anun so li ci te d o fferto pu rch as e th e La Jo ll a p ro pe rty for $ 16 mil li on . The p ur ch as e p ric e was subs eque nt ly reneg ot ia te d fo r $1 4,5 00 ,00 0 p lu s a s ha re o f th e h om e sa le s p ro fit s. Cen te x Ho m es pu rch as edth e p ro pe rty from GDLP in20 02 to de ve lo p re si de nt ia l to wnh ou se s l arg el y

on th e b as is of p rev io us pl an s tha t M r. Farg o’s en ti ti es de ve lo pe d. Th e sa le co nt ractbe twee n GDLP an d C en te x Ho m es ob li ga te d GDLP to co nt in ue it s b es t ef

fo rts with the de ve lo pm en t p ro ces s al read y inpl ace. Aft er Cen te x Ho m es pu rch as edth e p ro pe rty, GD LP in curredsubs eque ntde ve lo pm en t- 9 -

[* 9] co st s tha t wer e rei m

burs edby Cent ex Hom es . In 2 00 4 GDLP s ue d C en te x Hom es . As a res ul t o f th e li ti ga ti on , Cen te x Ho m es pa idGDLP an ad di ti on al $1 ,50 0,0 00 inful l s at is fact io n o f an y am ount s tha t m ay

have be endu e und er the
sa le co nt ract . C. GDLP’ s B as is forCo m pu ti ng th e Gai n o n S al e In20 02 GDLP calc ul at edit s b as is inth e La Jo ll a p ro pe rty, acco un ti ng for pr e-2 00 1 c ap it al iz edde ve lo pm en t co st s o f $6 13 ,06 0, a p aym en t o f $1 08 ,53 1 t o GPC fo r in te res t o n alo an , a pa ym en t o f $3 60 ,00 0 t o GPC fora de ve lo pm en t fe e, a p aym en t o f $3 03 ,05 7 t o GPC forin te res t o n t he de ve lo pm en t fe e, an d a n un reco nc il eddi ffer en ce o f $5 18 ,00 0. D. Farg o a ndKin g’s Fo rm 10 40 On Se pt em

be r 16 , 20 02 , GMC p ai d GPC an“ in cen ti ve de ve lo pm en t fe e” o f $4 56 ,00 0 o n GDLP’s b eh al f ba se d o n t he sal e p ric e o f th e p ro pe rty andpa idKRE
an“ ad di ti on al sal es co m

m is si on ” o f $3 50 ,00 0. OnDecem be r 17 , 20 02 , GMC wire tra ns ferr ed$5 00 ,00 0 t o F IC al so onGDLP’ s b eh al f. GDLP hadsu ffi ci en t fund s t o p ay

th e fee s atth e ti m e o f th e p aym en ts . GMC d educ te d t he $1 ,30 6,0 00
on it s Fo rm

11 20 S, U.S. Inc om e Tax Return fo r anS Co rp or at io n, fo r 20 02 , whi ch flo wedth ro ug h t o M r. Farg o a ndMs . Kin g’s jo in t Fo rm 10 40 , U.S. Ind iv idua l In co m e Tax Return, fo r 20 02 . Thes e were t he on ly paym en ts m ad e b y GMC o n- 10 -

[* 10 ] be ha lf o f GDLP. The o nl y ag reem en t tha t ex is te d b etweenGMC an d GDLP
was th e p artne rs hi p a gr eem en t, an d i t d idno t g en eral ly obl ig at e GMC t o p ay GDLP’ s ex pe ns es . On J anua ry

14 , 20 02 , Norb y

fil edan ot he r la wsu itag ai ns t Fa rg o a ndKin g a s well as GDLP, GMC , FIC, KRE, an d GPC . Norb y als o o bt ai ne d atem

po rary res tra in in g o rd er p ro hi bi ti ng th e es cro w com pa ny from

di st rib ut in g t he sal e pr oc eed s fr om

th e La Jo ll a p ro pe rty to GDLP u nt il th e d is pu te was re so lv ed
. Nor by ent eredin to a co m

pr eh en si ve set tl em en t ag reem en t wi thth e Far go pa rti es whi chco nt ai ne d num ero us pro vi si on s re ga rd in g t he pay m en ts an d d is tri bu ti on s be twee n andam on g a ll of t he affe ct edpa rti es an d e nt it ie s. Inrel ev an t p art , th e se tt le m en t ag reem en t s ti pu late d t ha t GDLP co ul d p ay th e in cen ti ve de ve lo pm en t fee o f $4 56 ,00 0 t o GPC , bu t o nl y to th e ex te ntof t he Cen te x Ho m es pro fit pa rti ci pa ti on an d wi th ou t i nt eres t. The set tl em en t ag reem en t al so st ip ul at edth at GDLP cou ldret ai n $ 50 0,0 00 to pa y GMC fo r m an ag em en t co m pe ns at io n. Farg o a ndKin g’s h om e was refi na nc edm ul ti pl e ti m es . In 2 00 2 F arg o a nd Kin g re fin an ceda lo anof $ 1,4 70 ,00 0 wi tha lo anfro m th e sa m e le nd er o f $1 ,59 0,0 00 , andth e n eg at iv e am orti zedin te res t was rol le d i nt o t he ne w lo an pr in ci pa l. Mr . Farg o a ndMs . Kin g app li edth ei r al le ge d re m ai ni ng ne t o pe rat in g lo ss carry fo rwardba lanc e o f $1 ,10 7,1 05 on th ei r Fo rm 10 40 for20 02
.- 11 -

[* 11 ] OPINION I. Burd enof P ro of Gen eral ly, th e ta xp ay er b ears th e b ur de n o f pr ov in g, b y a pr ep on de ran ce o f th e ev id en ce, tha t the de te rm in at io ns of t he Co m m is si on er i n ano ti ce o f de fic ie nc y are i nc orrect . Rul e 1 42 (a); W el chv. Hel ve rin g, 2 90 U.S. 11 1, 1 15 (19 33 ). Deduc ti on s ar e a m at te r of leg is la ti ve gra ce, an d atax pa y er b ears th e b ur de n o f pr ov in g e nt it le m en t t o a ny clai m edde du ct io ns . Rul e 1 42 (a)( 1) ; INDOPC O, Inc . v. Co m m is si on er, 5 03 U.S. 79 , 84 (19 92 ). The b ur de n o f pr oo f on factua l i ss ue s tha t affe cta ta xp ay er’s l iabi li ty for t ax m ay sh iftto th e Co m

mis si on er i f certa in cri te ria
are m et . Sec. 7 49 1( a)(1 ). Pet it io ne rs have no t ar gu edor o th erwi se de m on st rat ed th atsec ti on 74 91 ap pl ie s an d t he refo re b ear t he bu rd enof p ro of with re sp ectto th e in co m e ta x a dju st m en ts . II. Ch arac te r of

Inc om e The se cas es pre se ntth e que st io n o f whe th er g ai n fr om th e sa le of r eal pr op erty res ul te d i n o rd in ary in co m e o r cap it al ga in
. Res po nd en t co nt en ds th at 4 th e sa le of t he La Jo ll a p ro pe rty to C en te x Ho m es pro du cedord in ary in co m e.

Thi s i ss ue was fo r de ci si on so le ly in the cas e atdo ck etNo. 1 66 -1 3. 4 Howev er, s in ce GDLP is a pa ss th ro ug h e nt ity , we wou ldpre su m e th atth e cal cu la ti on wou ldflo w th ro ug h t o F arg o a ndKin g i n the Ru le 15 5 c om pu ta ti on .- 12 -

[* 12 ] GDLP argu es th e sa le pro du cedcap it al ga in be cau se ithe ldth e la ndfor in ve st m en t. Sect io n 1 22 1( a)(1 ) de fin es a cap it al ass etas “ pr op erty he ldby the tax pa y er * * * b utdo es no t i nc lu de * * * p ro pe rty hel d b y th e ta xp ay er p rimaril y

forsal e to cu st om ers inth e o rd in ary co ur se of h is tra de or b us in es s” . Sect io n 1 22 1( a)(2 ) pr ov id es th ata “ cap it al ass et ” d oe s n otin cl ud e “ real pro pe rty us edin* * * [t he ta xp ay er’s] trad e o r bu si ne ss ”. The Supr em e Co urt h as he ldth atitis ap pr op ria te to co ns tru e th e d efi ni ti on of cap it al ass etna rro wly whi le si m ul tane ou sl y

co ns tru in g t he Co de ’s def in it io n o f
ex cl us io ns fro m

cap it al ass etst atus bro ad ly. Co m m is si on er v . Gil le tt e Mo to r Tran sp ort, In c., 36 4 U.S. 1 30 , 13 4- 13 5 (1 96 0)
. Whe th er a t ax pay er h el d s pe ci fie d p ro pe rty pri m ari ly for s al e to cu st om ers in th e o rd in ary co ur se of b us in es s i s a que st io n o f fac t. Ro ckwell v. Co m m is si on er, 5 12 F.2d88 2, 8 84 (9t h C ir. 1 97 5) , aff’g T.C. Mem o. 1 97 2- 13 3. The term “pr im ari ly” for p ur

po se s o f se ct io n 1 22 1( a)(1 ) m ean s “ of fir st im po rta nc e” o r “pr in ci pa ll y ”. See M al atv. Ri dd el l, 3 83 U.S. 56 9, 5 72 (19 66 ). Thi s C ou rt h as id en ti fie d s ev eral fact or s fo r ev al ua ti ng whet he r a t ax pay er h el d cert ai n p ro pe rti es pri m ari ly for s al e to cu st om ers inth e o rd in ary co ur se of bu si ne ss , in cl ud in g: (1) th e p ur po se forwhi chth e p ro pe rty was in it ia ll y acqui red ;- 13 -

[* 13 ] (2) th e p ur

po se forwhi chth e p ro pe rty was s ub se qu en tl y he ld ; (3 ) th e ex te nt to whi chim

pr ov em en ts , if an y , were m ad e to th e p ro pe rty by th e ta xp ay er; (4) th e freque nc y , nu m

be r, an d c on ti nu ity

of s al es ; (5 ) th e ex te ntan d n atur e o f th e tra ns act io ns in vo lv ed ; (6 ) th e o rd in ary bu si ne ss of t he tax pay er; (7) th e ex te ntof adve rti si ng , pro m ot io n, o r ot he r act iv e effo rts us edinso li ci ti ng bu y ers forth e sa le of th e p ro pe rty; (8 ) th e li st in g o f pr op erty with b ro ke rs ; an d (9 ) th e p ur po se for whi chth e p ro pe rty was h el d a t the ti m e o f sa le . Mad du x C on st r. Co . v. Co m m is si on er, 5 4 T.C. 1 27 8, 1 28 4 (1 97 0) . W e m us t d eci de each cas e upo n i ts pa rti cu lar fac ts , andth e p res en ce o f an y on e o r m or e o f th es e fac to rs m ay or m ay no t b e d et erm in at iv e o f a p art ic ul ar ca se . Redwoo d Em pi re Sav. & Loan Ass ’n v. Co m m is si on er, 6 28 F.2d51 6, 5 17 (9t h C ir. 1 98 0) , aff’g 6 8 T.C. 9 60 (19 77 ). Upo n re vi ew of

th e rel ev an t fa ct or s, we co nc lu de th atGDLP has no t su ffi ci en tl y

est ab li sh edth e fac ts ne ces sary to it s ca se , no r ha s i t ca rri edit s b ur de n of pro vi ng res po nd en t’s d et erm in at io ns were i n e rro r.

1. Th e Pu rp os e fo r Whi chth e Pro pe rty W as Ini ti al ly A cqui red GDLP andres po nd en t ag ree t ha t the in it ia l i nv es tm en t i n t he La Jo ll a pr op erty was fo r de ve lo pm en t p ur po se s. Th is is ev id en cedby FIC’s ori gi na l in te ntwhen itacqui redth e le as eh ol d i n 1 98 9 t o d ev el op th e La Jo ll a p ro pe rty for
res al e to cu st om ers . GDLP’ s 1 99 7 p ur ch as e o f th e La Jo ll a p ro pe rty in f ee s im pl e- 14 -

[* 14 ] to im

pr ov e ch an ces of o bt ai ni ng de ve lo pm en t fi na nc in g fu rth er ev id en ces it s in te nt . Howev er, al th ou gh a ta xp ay er’s i ni ti al m ot iv at io n i n a cqui rin g p ro pe rty is rel ev an t, the ul ti m at e que st io n i s the tax pay er’s p ur po se at t he ti m e o f sa le
. Mad du x C on st r. Co . v. Co m m is si on er, 5 4 T.C. at12 86 . It i s cl ear t ha t GDLP in it ia ll y acqui redth e La Jo ll a p ro pe rty in t he no rm al co ur se of b us in es s, b utth e cru ci al fact oris th e p ur

po se forwhi chth e La Jo ll a p ro pe rty was h el d a t the ti m e o f
sa le
. 2. Th e Pu rp os e fo r Whi chth e Pro pe rty W as Subs eque nt ly H el d GDLP con te nd s tha t i t h el d t he La Jo ll a p ro pe rty pri m ari ly to al lo w th e La Jo ll a rea l es ta te m ark etto reco ve r fro m th e rec es si on ; thu s, i t s ho ul d b e v ie wedas anin ve st m en t. Itis well est ab li sh edth ata ta xp ay er i n t he real est at e b us in es s m ay ho ldreal est at e as anin ve st m en t. Ro us e v . Comm is si on er, 3 9 T.C. 7 0 (1 96 2)
. Altho ug h we b el ie ve th atGDLP hel d t he La Jo ll a p ro pe rty, in p art , to all ow th e m ark etto reco ve r, we th in k t ha t was no t GDLP’s pr im ary pu rp os e. GDLP
ne ve r ab an do ne d i ts de ve lo pm en t p lan, as ev id en cedby its m ul ti pl e at te m

pt s t o ob ta in fin an ci ng an d b y

th e ex pe ns es itin curredfor arch it ectur al , eng in eeri ng , and ap pr ai sa l fe es . GDLP inc urredsubs tant ia l fe es rel at in g t o d ev el op m en t ex pe ns es , with a n a ccu m

ul at edba lanc e o f $1 ,82 8,9 82 at t he en d o f 20 01 . The d ev el op m en t- 15 -

[* 15 ] ex pe ns es were i nc urredeach y ear b etween19 91 an d 2 00 1, i nd ic at in g tha t th e d ev el op m en ta l ef

fo rts were o ng oi ng . This fact orweig hs infav orof
res po nd en t. 3. Th e Ext en t o f Im pr ov em en ts to th e Pro pe rty GDLP con te nd s tha t dur in g t he 10 y ears ithe ldth e La Jo ll a p ro pe rty it
ne ve r bu il t an y

stru ctur es , roa ds , or dwell in gs of a ny kin d. Al th ou gh GDLP nev er to oksubs tant ia l ac ti on s t o i m pr ov e th e La Jo ll a p ro pe rty, it d idin cu r $7 0,4 07 of
accu m ul at edlea se ho ldim

pr ov em en ts as o f th e en d o f 20 01 . Som e o f th es e im pr ov em en ts , in cl ud in g ane w roo f fo r th e b ui ld in g, wer e m or e p ro pe rly ch arac te riz edas g en eral rep ai rs an d m ai nt en an ce. GDLP arg ue s tha t the im pr ov em en ts were k ep t t o am in im um , evi de nc edby the factth e b ui ld in g’s he at in g s y st em

an d e le va to r rem ai ne d i n d is rep ai r. On the ba si s o f th e le as eh ol d im pr ov em en ts alo ne , we bel ie ve th atGDLP nev er s ub st an ti al ly im pr ov edth e La Jo ll a p ro pe rty.

4. Th e Fre qu en cy , Num

be r, an d C on ti nu ity

of S al es W e h av e p rev io us ly hel d t ha t fr eque ntan d s ub st an ti al sal es of r eal pro pe rty
m or e li ke ly ind ic at e sa le s i n the ord in ary co ur se of b us in es s wh erea s i nf reque nt sa le s fo r si gn ifi can t p ro fit s ar e m or e in di cat iv e o f rea l p ro pe rty hel d a s an- 16 -

[* 16 ] in ve st m en t. Ph el anv. Co m m is si on er, T.C. Mem o. 2 00 4- 20 6. Re sp on de nt arg ue s tha t GDLP was inth e b us in es s o f rea l es ta te de ve lo pm en t fo r sa le to co ns um ers . GDLP hadne ve r so ldreal est at e b efo re the sal e o f th e La Jo ll a p ro pe rty, but ot he r en ti ti es th atMr. Far go own edde ve lo pe d a ndso ldreal est at e in th e n orm al
co ur se of b us in es s. Ho wev er, o n t he se fact s we b el ie ve GDLP’ s ac ti vi ty alo ne sh ou ldbe ou r fo cu s, an d we f in d t hi s fa ct or

fav or s GDLP. See i d., s li p o p. at15
- 20
. 5. Th e Ext en t an d Natur e o f th e Tran sa ct io ns Inv ol ve d It i s u nd is pu te d t ha t the sal e o f th e La Jo ll a p ro pe rty was th e o nl y sal e as so ci at edwith t hi s tran sa ct io n. Th e p ro pe rty was s ol d t o C en te x Ho m es , an un rel at eden ti ty, ata fai r pr ic e wit h t he pl anforMr. Far go to de ve lo p t he pro pe rty an d GDLP t o s ha re i n t he res ul ti ng pro fitacco rd in g t o t he term s o f th e p ur ch as e ag reem en t. GDLP an d M r. Farg o wer e cl earl y in te res te d i n t he de ve lo pm en t p ro fit atth e ti m e o f th e sa le . There fo re, thi s fa ct or fav or s re sp on de nt . 6. Th e Ext en t o f Adv ert is in g, Pr om ot io n, o r Oth er Act iv e Effo rts UsedinSo li ci ti ng Buy ers for th e Sal e o f th e Pro pe rty It i s u nd is pu te d t ha t Ce nt ex Hom es m ad e anun so li ci te d o fferto pu rch as e th e La Jo ll a p ro pe rty, anditis als o u nd is pu te d t ha t GDLP was no t ac ti ve ly- 17 -

[* 17 ] adve rti si ng or p ro m ot in g i ts sal e aro un d t he ti m e itwas s ol d. Th e o nl y effo rt th atGDLP m ad e to sel l i t was co nt ract in g wi thGPC in 19 93
. InMad du x C on str. Co . v. Co m m is si on er, 5 4 T.C. at12 85 , th e ta xp ay er si mil arl y di sc us se d apro pe rty sal e wit h areal est at e b ro ke r bu t d idno t m ak e an y ot he r effo rt t o s el l the pro pe rty. W e h el d t ha t the tax pay er d idno t m ak e ex te ns iv e effo rts to sel l the pro pe rty with th atact io n a lo ne . Here, GDLP di d n oten ga ge in
m ark et in g, s el li ng , or a dv ert is in g o ut si de of c on tra ct in g wi th GPC. Furth er, GPC
ne ve r co nt act edan y

bu y ers or p erfo rm edsubs tant ia l m ark et in g o r adve rti si ng se rv ic es . Con se qu en tl y , GDLP has carri edth e b ur de n o f sh owi ng th atitdi d n ot
m ak e ex te ns iv e eff

orts to sel l the La Jo ll a p ro pe rty. 7. Th e Lis ti ng of t he Pro pe rty W ith B ro ke rs The La Jo ll a p ro pe rty was li st edwith GPC servi ng as b ro ke r in 19 93
. Add it io na ll y , th e rec or d i nd ic at es th atGPC was pa ida fee b as edon th e sa le pri ce. Thi s fa ct or

weig hs infav orof GDLP. 8. Th e Pu rp os e fo r Whi chth e Pro pe rty W as Heldat the Tim e o f Sal e At the ti m e Cen te x Ho m es pu rch as edth e La Jo ll a p ro pe rty GDL P h ad in cu rredsubs tant ia l d ev el op m en t co st s an d und ert ak ensev eral strat eg ic m ov es to acqui re fi na nc in g t o fu ndde ve lo pm en t. At the ti m e o f sa le GDLP hadbe en co nt in uo us ly inc reas in g i ts de ve lo pm en ta l ef fo rts with re sp ectto th e La Jo ll a- 18 -

[* 18 ] pro pe rty. D ur in g 1 99 9 a nd20 00 GDLP in cu rredde ve lo pm en ta l co st s o f $2 33 ,00 0 a nd$2 16 ,33 7, re sp ect iv el y , whi chrep res en t a s ub st an ti al po rti on of t he to ta l s pe nton de ve lo pm en t o ve r th e en ti re h ol di ng pe rio d. Un li ke th e ta xp ay er i n Mad du x, wh ic h h adst op pe d d ev el op in g t he pro pe rty two years b efo re the sal e, GDLP con ti nu al ly eng ag edineffo rts to pl anan d d ev el op th e La Jo ll a p ro pe rty up un ti l the pu rch as e d at e. See i d. at12 87 . Con se qu en tl y , th is fact orwou ldno t supp ort the co nc lu si on th atth e La Jo ll a p ro pe rty was h el d s im pl y as a n i nv es tm en t atth e ti m e o f sa le
.

9. Co nc lu si on Und er the fact or s d is cu ss edab ov e, we ho ldth atGDLP so ldth e La Jo ll a pr op erty inth e o rd in ary co ur se of b us in es s u nd er s ect io n 1 22 1( a)(1 ). GDLP pu rch as edan d h el d i t p rimaril y to de ve lo p i t an d l at er s el l i t t o c us to m ers . This in te ntwas n ev er ab an do ne d a ndrem ai ne d t he pri m ary m ot iv e fo r ho ld in g t he La Jo ll a p ro pe rty as p artof r eg ul ar b us in es s ac ti vi ti es . In ad di ti on , GDLP inc urred si gn ifi can t d ev el op m en t ex pe ns es . Thu s, GDLP h as fai le d t o s ho w th atga in fro m th e sa le of t he La Jo ll a p ro pe rty was n otsubjec t t o o rd in ary in co m e tr eat m en t un de r se ct io n 1 22 1( a)(1 ). W e rec og ni ze tha t the La Jo ll a p ro pe rty was u se d a s a r en ta l p ro pe rty and GDLP andall rel at eden ti ti es m ai nt ai ne d t he ir o ffi ces on th e p ro pe rty. H owe ve r,- 19 -

[* 19 ] us in g t he La Jo ll a p ro pe rty as ren ta l p ro pe rty was n otGDLP’ s p rimary pu rp os e o f ho ld in g i t. We hel d i n C ot tl e v . Comm is si on er, 8 9 T.C. 4 67 (19 87 ), th atsec ti on 12 31 cap it al ga in tre atm en t was ap pl ic ab le to a ren ta l p ro pe rty subs eque nt ly sol d t o l iqui da te th e in ve st m en t. Tha t i s n otth e cas e h ere. GDLP
was m ak in g i ts be stus e o f th e La Jo ll a p ro pe rty as o ffi ce an d re nt al sp ace wh il e ne ve r ab an do ni ng it s p rimary in te nt io n, s el li ng it
. III. Cal cu la ti on of B as is inth e Pro pe rty Inge ne ral , tax pa y ers m

us t re co gn iz e g ai n wh enth ey sel l p ro pe rty for m or e th anit s ad

jus te d b as is . Sec. 1 00 1( a); sec . 1.6 1- 6( a), In co m e Tax Reg s. Tax pa y ers m ay ad jus t the ba si s o f th e p ro pe rty for ex pe nd itur es , recei pt s, l os se s, o r ot he r it em s p ro pe rly char ge ab le to th e cap it al acco un t, b utth ey ge ne ral ly bear the bu rd enof p ro vi ng ba si s i nc reas es th ey cla im . See s ec. 1 01 6( a); Ru le 14 2( a); sec . 1.1 01 6- 2( a), In co m e Tax Reg s. Th e b ur de n m ay sh iftto th e Co m

m is si on er i f th e ta xp ay er i nt ro du ces cred ib le ev id en ce s up po rti ng a ba si s i nc reas e. See s ec. 74 91 (a)( 1) . Taxp ay ers are re qu ire d t o k eep su ffi ci en t re co rd s t o s ub st an ti at e th ei r gr os s i nc om e, de du ct io ns , cred it s, an d o th er t ax att rib ut es . Sec. 6 00 1; see als o s ec. 1.6 00 1- 1( a), In co m e Tax Reg s. If t ax pa y ers can no t p ro du ce re co rd s o f actua l
ex pe nd itur es affe ct in g b as is , we m ay est im at e th e am ou nt s o f ex pe ns es if the y- 20 -

[* 20 ] pro vi de cred ib le ev id en ce tha t es tabl is he s a f actua l b as is forth e es ti m at e. See C oh anv. Co m

mis si on er, 3 9 F .2d54 0 (2 d C ir. 1 93 0)
. A. Capi ta li zedDeve lo pm en t Co st s B efo re 2 00 1 Res po nd en t d is al lo wed$6 13 ,06 0 i n c ap it al iz edde ve lo pm en t co st s i nc urred be fo re 2 00 1. GDLP st at es th e d ev el op m en t co st s wer e fo r pe rm it s, ar ch it ect s, en gi ne ers , andot he r de ve lo pm en t ac ti vi ti es . Thes e co st s wer e in cu rredov er a nu m be r of y ears inco nn ect io n wi th th e p ur ch as e b y FIC o f th e le as eh ol d i nt eres t of La Jo ll a Me di cal Bu il di ng Co rp . Res po nd en t ar gu es th e cap it al iz edde ve lo pm en t co st s m us t b e d is reg ard ed be cau se to o m

uc h abo utth e cl ai m edco st s i s unkno wn. Ma ny Fargo en ti ti es were en ga ge d i n s ev eral de ve lo pm en t p ro jects si m ul tane ou sl y . The d ev el op m en t at is su e, al on g wi th th e o th er p ro jects , was m an ag edby a sm al l t eam of a cco un tant s an d b oo kk eep ers . Res po nd en t ar gu es th atitis li ke ly that m is ta ke s wer e m ad e in
reco rd in g e xp en se s o n a cco un t o f th e co m m on al ity of e xp en se s among th e p ro jects
an d p oi nt s t o t he in ab il ity of the acco un tantto expl ai n s om e o f th e n om en cl atur e at tri al . GDLP argu es itpro vi de d s uf fic ie ntev id en ce t o s ub st an ti at e th e cap it al iz ed
ex pe ns es an d c orro bo rat edth e ev id en ce wi th cred ib le tes ti m on y . W e ag ree wi th GDLP.- 21 -

[* 21 ] Afte r co ns id eri ng th e te st im on y of abo okke ep er an d g en eral led ge rs ke ptby GDLP, we fin d GDLP s ub st an ti at edth e cap it al iz edde ve lo pm en t co st s. We ho ld th atGDLP is en ti tl edto in cl ud e th e cap it al iz edde ve lo pm en t co st s i nc urredbe fo re 20 01 inth e b as is
. B. In te res t Pa idto GPC Res po nd en t d is al lo wed$3 03 ,05 7 i n i nt eres t p aym en ts on a de ve lo pe r fee to GPC. Res po nd en t ar gu es th atth e in te res t p aym en ts were n otsubs tant ia te d a ndth e de ve lo pm en t ag reem en t b etweenGDLP andGPC was si le ntas t o t he pa ym en t o f th e in te res t an d t he ap pl ic ab le in te res t ra te . Furt he r, res po nd en t n ot es th atNorb y wou ldha ve ap pr ov edth e in te res t p aym en t fo r a num be r of reas on s n otrel at edto th e v al id ity

of t he pa ym en t. GDLP arg ue s i t p ro vi de d s uf fic ie ntev id en ce t o subs tant ia te th e cap it al ex pe ns e en try andth atNorb y , an u nr el at edpartn er, ap pr ov edth e in te res t p aym en t t o GPC
. Co ns id eri ng th e ev id en ce, we fi ndth atGDLP di d s ub st an ti at e th e cap it al
ex pe ns e. GDLP pro vi de d g en eral led ge rs , th e d ev el op m en t ag reem en t, an d cred ib le tes ti m on y . W e d o n otfin d i t n eces sa ry to co nt em

pl at e th e rea so n No rb y ap pr ov edth e in te res t p aym en t.- 22 -

[* 22 ] C. Depr eci at io n Al lo wedor Al lo wab le Res po nd en t re du cedth e b as is of t he La Jo ll a p ro pe rty by $8 78 ,61 3 fo r de pr eci at io n a ll owe d o r al lo wab le . Depre ci at io n i s al lo wedforpro pe rty us edina tra de or b us in es s an d p ro pe rty hel d fo r th e p ro du ct io n o f in co m e. Sec. 1 67 . A le as eh ol d o f la ndus edina tr ad e o r bu si ne ss m ay be pro pe rty of a ch arac te r whi ch is subjec t t o the all owanc e fo r de pr eci at io n p ro vi de d i n s ect io n 1 67 . See Ce ntury Elec . Co. v . Comm is si on er, 1 92 F.2d15 5, 1 60 (19 51 ), aff’g 1 5 T.C. 5 81 (19 50 ); Fack le r v. C omm is si on er, 1 33 F.2d50 9, 5 12 (19 43 ), aff’g 4 5 B .T.A 708 (19 41 ); Ci ty N at ’l Ban k B ld g. Co . v. Hel ve rin g, 9 8 F .2d21 6, 2 19 (19 38 ), aff’g 3 4 B .T.A. 93 (19 36 ); B ak er v . Comm is si on er, 3 8 T.C. 9 , 12 (19 62 ). Sect io n 1 78 pro vi de s ru le s fo r de te rm in in g t he am ountof d ep reci at io n o r am orti zat io n d educ ti on al lo wab le to a le ss ee fo r bo th th e co stof a cqui rin g alea se an d fo r im pr ov em en ts
m ad e o n l eas edpro pe rty. Sec. 17 8; sec . 1.1 78 -1 , Inc om e Tax Reg s. Re sp on de nt arg ue s tha t GDLP’s ba si s i n the La Jo ll a p ro pe rty sh ou ldbe reduc edby the de pr eci at io n a ll owabl e fo r th e te rm of t he lea se . This is a factua l que st io n. FIC a cqui redit s l eas eh ol d i nt eres t i n Dec em be r 19 88 . The l eas e h ada te rm en di ng Aug us t 3 1, 2 00 8. Th e le as e was actua ll y term in at edwhenGDLP pu rch as eda fee s im

pl e in te res t i n t he pro pe rty onDecem be r 31 , 19 97 . The i ss ue was no t cl earl y

fram edby the FPAA orth e p le ad in g, an d we f in d i t i s a “ ne w- 23 -

[* 23 ] m atte r” u nd er Ru le 14 2( a)(1 ), su chth atres po nd en t b ears th e b ur de n o f pr oo f. The reco rdbe fo re u s u nd ers tand ab ly is n otcle ar o n the cir cum st an ces fro m Decem be r 19 88 un ti l Dec em

be r 31 , 19 97 . The fac ts ne ces sa ry to est ab li sh whe th er d ep reci at io n was all owe d o r al lo wab le are n otinth e rec or d. Th eref or e, we wil l n otpre su m e th es e fac ts fav or ab le to res po nd en t, an d we d o n otup ho ldth is ad jus tm en t t o b as is
. D. Adjus tm en ts Pet it io ne rs DidNotAddres s o n B rie f Res po nd en t d is al lo wedGDLP’ s l oa n i nt eres t p aym en t o f $1 08 ,53 1 t o GPC
an d a n une xp la in eddi ffer en ce o f $5 18 ,86 1 b etweenres po nd en t’s d et erm in at io n o f ba si s an d t he ba si s GDLP cl ai m edon it s Fo rm 10 65 , U.S. Returnof P artne rs hi p In co m e, fo r 20 02 . Adjus tm en ts no t ad dr es se d i n a ny of p et it io ne rs ’ br ie fs are de em edto be co nc ed ed . See Rybakv. Co m m is si on er, 9 1 T.C. 5 24 , 56 6 (1 98 8)
. W e th eref

or e h ol d t ha t GDLP’s ba si s m us t b e reduc edby the se am ou nt s. IV. Vali di ty of Deduc ti on s C ha ract eri zedas Ord in ary an d Nec es sa ry Bu si ne ss Exp en se s Deduc ti on s ar e a m at te r of leg is la ti ve gra ce, an d t axpa y ers m us t m ai nt ai n su ffi ci en t re co rd s t o s ub st an ti at e th e am ou nt s o f th ei r in co m e an d e nt it le m en t t o an y de du ct io ns or c red it s cl ai m ed . Rul e 1 42 (a)( 1) ; INDOPC O, Inc . v.- 24 -

[* 24 ] Co m

m is si on er, 5 03 U.S. at 8 4; New Co lo ni al Ice Co . v. Hel ve rin g, 2 92 U.S. 43 5, 4 40 (19 34 ). A tax pa y er m ay de du ctord in ary an d n eces sa ry ex pe ns es pa idor in cu rreddu rin g t he tax ab le y ear i n c arrying on an y tra de or b us in es s. Sec . 16 2. Whe th er an ex pe ns e is ord in ary is de te rm in edby tim e, pl ace, andcir cum st an ce. W el chv. Hel ve rin g, 2 90 U.S. at 1 13 -1 14 . W he re a t ax pay er re po rts a bu si ne ss ex pe ns e b utcan no t fu ll y

subs tant iate it , th e Co urt g en eral ly m ay ap pr ox im at e th e al lo wab le am ou nt . Coh anv. Co m m is si on er, 3 9 F .2d54 0 a t 5 43 -5 44 . Howev er, we m ay do so on ly whe n t he tax pa y er p ro vi de s ev id en ce s uf fic ie ntto est ab li sh a rat io na l b as is up on whi chanest im at e can be m ad e. Vani cekv. Co m m is si on er, 8 5 T.C. 73 1, 7 43 (19 85 ). Res po nd en t d is al lo wedGMC’s d educ ti on s t ot al in g $ 1,3 06 ,00 0 wh ic h flo wedth ro ug h t o M s. Ki ng onth e b as is th atth e fee s wer e n otord in ary an d
ne ces sa ry bu si ne ss expe ns es . Thes e d educ ti on s wer e m ad e up o f a $ 35 0,0 00 real
es ta te co m

m is si onfee t o KRE, a $ 45 6,0 00 de ve lo pm en t fe e to GPC, an d a $5 00 ,00 0 d ev el op m en t fe e to FIC. Far go an d Ki ng arg ue th atth es e ex pe ns es were or di na ry an d n eces sa ry

as c om pe ns at io n fo r se rv ic es pe rfo rm edby the en ti ti es un de r co nt ractua l ag reem en ts . Farg o a ndKin g fa il edto pro ve th atth es e expe ns es were o rd in ary an d
ne ces sa ry bu si ne ss expe ns es . Farg o a ndKin g c it e n o e vi de nc e th atth e rel at ed- 25 -

[* 25 ] en ti ti es were en ti tl edto th e co m m is si on fee an d d ev el op m en t fe es rece iv ed
. The co nt ract s GDLP h adwith GPC an d F IC were form ark et in g s erv ic es , y etth e La Jo ll a p ro pe rty was n otbe in g a ct iv el y m ark et ed . Furt he r, th ere i s n o e vi de nc e th atKRE was en ti tl edto a co m m is si on fee o ve r th e $ 52 0,0 00 fee KRE re cei ve d at th e cl os e o f es cro w. Evenif we fo un d the ex pe ns es to be ord in ary an d n eces sa ry , Farg o a ndKin g fa il edto subs tant ia te th em . The am ou nt s o f th e d educ ti on s wer e no t s up po rte d b y

th e co nt ract s, an d F arg o a ndKin g c ou ldno t re cal l dur in g t ria l ho w th e p aym en ts were ca lc ul at ed . W e are un ab le to ap pr ox im at e th e al lo wab le de du ct io ns on acco un t o f th e la ckof s uf fic ie ntev id en ce. Furth er, GMC pa idth e fee s as th e g en eral pa rtn er o f GDLP forco nt ract s an d fe es th atGDLP wou ldha ve be enli ab le for . A partne r can no t d ire ct ly deduc t th e ex pe ns es of t he pa rtn ers hi p u nl es s the re i s an ag reem en t am on g t he partn ers th atsu chex pe ns es sh al l b e b orne by the pa rtn er i nd iv idua ll y ou t o f it s o wn fu nd s. See Dep ut y

v. du P on t, 3 08 U.S. 48 8, 4 94 (19 40 ); Welc h v . Helv eri ng , 29 0 U.S. at 11 4- 11 5; Cro pl an d C he m . Cor p. v . Comm is si on er, 7 5 T.C. 2 88 (19 80 ). The pa rtn ers hi p a gr eem en t h el d GM C, as th e g en eral pa rtn er, l iabl e fo r co st s wh en in co m e an d a ss et s o f GDLP were i ns uf fic ie nt . GDLP hadsu ffi ci en t fu nd s t o p ay th e fee s. Th ere was no ag reem en t b etweenGMC an d GDLP fo r GMC t o p ay th e- 26 -

[* 26 ] fees , asi de fro m

th e p artne rs hi p a gr eem en t. The refo re, GMC can no t d educ t th e tr ad e o r bu si ne ss expe ns es of GDLP u nd er the ge ne ral rul e. The ex cep ti on to th is ge ne ral rul e ap pl ie s upo n t he sat is fact io n o f a twopr on g t es t: (1) whet he r th e ta xp ay er’s p ur po se or m ot iv e fo r pa y in g t he ob li ga ti on of th e o th er en ti ty is t o p ro te ctor p ro m ot e th e ta xp ay er’s o wn trad e o r bu si ne ss ; an d (2 ) whe th er the ex pe nd itur e is anord in ary an d n eces sary ex pe ns e o f th e ta xp ay er’s o wn trad e o r bu si ne ss . Loh rk e v . Comm is si on er, 4 8 T.C. 6 79 , 68 8 (1 96 7) ; Di etric k v . Commis si on er, T.C. Mem o. 1 98 8- 18 0, af f’d, 88 1 F .2d33 6 (6 th Ci r. 19 89 ). Farg o a ndKin g d o n otsat is fy bo th pro ng s o f th e te st . As st at edab ov e, GMC’s ex pe nd itur es were n otanord in ary an d n eces sa ry ex pe ns e o f it s o wn trad e orbu si ne ss . Farg o a ndKin g m ad e n o a rg um en t re ga rd in g t he ir p ur po se or m ot iv e fo r GMC’s p aym en t o f GDLP’ s o bl ig at io n. Ev enif the pu rp os e o r m ot iv e was to pr ot ector p ro m ot e GMC’s o wn trad e o r bu si ne ss , Farg o a ndKin g wo ul d s ti ll fai l th e two -p ro ng tes t as th e ex pe ns e was no t o rd in ary an d n eces sa ry . Accor di ng ly, we ag ree wi thres po nd en t tha t the ex pe ns es are n otde du ct ib le
. V. Whe th er GMC ’s Cla im edDedu ct io ns Are Dis tri bu ti on s t o M s. Ki ng A party m ay

no t ra is e a n ew is su e o n b rie f whe re co ns id erat io n o f th e is su e wou ldsu rp ris e o r pr ejud ic e th e o pp os in g p arty . See Sm al le y v. Co m mis si on er,- 27 -

[* 27 ] 11 6 T.C. 4 50 , 45 6 (2 00 1) ; 5 08 Cli nt on St. Co rp . v. Co m m is si on er, 8 9 T.C. 35 2, 3 53 n.2 (19 87 ). Farg o a ndKin g arg ue , for th e fi rs t t im e in th e p os ttria l b rie f, th atif we fi nd th e d educ ti on s d is cu ss edsupr a p artIV are n otord in ary an d n eces sary bu si ne ss ex pe ns es th enth ey

are d is tri bu ti on s t o M s. Ki ng . The p art ie s d idno t p ur su e fac ts orev id en ce tha t m ay

be ar o n t hi s i ss ue . Accor di ng ly, we wil l n otad dr es s thi s arg um en t. VI. App ro pr iate Adju st m en t t o NetOper at in g Lo ss Tax pa y ers att em

pt in g t o d educ t a n etop erat in g l os s (NOL) b ear, i n pa rti cu lar, th e b ur de n o f es tabl is hi ng bo th th e ex is te nc e o f th e NOL andth e am ountof a ny NO L th atm ay be carr ie d o ve r to th e subjec t years. Ru le 14 2( a)(1 ); Uni te d S tate s v . Olym

pi c Rad io & Tele vi si on , Inc ., 34 9 U.S. 2 32 , 23 5 (1 95 5) ; Keit h v . Comm is si on er, 1 15 T.C. 60 5, 6 21 (20 00 ). Suc h d educ ti on s ar e a m at te r of leg is la ti ve gra ce, n ota m at te r of rig ht . INDOPCO, Inc . v. Co m mis si on er, 5 03 U.S. at 8 4; Olym

pi c Rad io & Tele vi si on , Inc ., 34 9 U.S. at23 5; Depu ty v. duPo nt , 30 8 U.S. at49 3. Not withs tand in g t he ge ne ral rul e, if th e ta xp ay er p ro du ces cred ib le ev id en ce with re sp ectto an y

factua l i ss ue rel ev an t t o a sc ert ai ni ng hi s Fe de ral in co m e ta x li ab il ity , th e b ur de n o f pr oo f sh ift s fr om th e ta xp ay er t o the Co m

mis si on er as to- 28 -

[* 28 ] th atfactua l i ss ue . Sec. 7 49 1( a)(1 ). The s hi fti ng of t he bu rd enof p ro of , ho wev er, i s co nd it io ne d upo n t he tax pa y er’s fi rs t d em on st rat in g t ha t h e m etth e requi rem en ts of s ect io n 7 49 1( a)(2 ), in cl ud in g (1 ) subs tant ia ti ng an y it em as requi redby the Co de , (2) m ai nt ai ni ng all reco rd s re qu ire d b y th e Co de , and(3)
co op erat in g wi th th e Co m m is si on er’s rea so nabl e reque st s fo r witne ss es , in fo rm at io n, d oc um en ts , m eet in gs , andin te rv ie ws. Res po nd en t ar gu es th atFarg o a ndKin g’s NOL fo r 20 02 sh ou ldbe reduc ed by $1 50 ,66 9. Re sp on de ntde te rm in ed , onth e b as is of r ev ie w of Farg o a ndKin g’s 20 02 Fo rm

10 40 , th atFarg o a ndKin g wer e en ti tl edto de du cton ly $56 ,10 0 o f th e $1 31 ,12 2 m ortg ag e in te res t an d n on e o f th e $ 75 ,64 7 i nv es tm en t i nt eres t cl ai m ed fo r 20 01 forpu rp os es of d et erm in in g h ow m uc h o f th e ex is ti ng NOL was ab so rb ed in 20 01 . Farg o andKin g fa il edto subs tant ia te an y of t he m ortg ag e in te res t o r in ve st m en t i nt eres t p aym en ts rep orte d o n t he ir 2 00 1 re tu rn . W e ag ree wi th
res po nd en t tha t Farg o a ndKin g’s 2 00 1 NOL sh ou ldha ve ab so rb ed$1 50 ,66 9 o f th e rem ai ni ng NOL, redu ci ng th e av ai labl e NOL for 2 00 2 b y th e sam e am ou nt . VII. Deduc ti on for

Hom e Mo rtg ag e In te res t The ge ne ral rul e is th at“ [t]he re s ha ll be all owe d a s a d educ ti on all in te res t pa idor a ccru edwithi n t he tax ab le y ear o n i nd eb te dn es s.” Se c. 16 3( a).- 29 -

[* 29 ] Deduc ti on s ar e a m at te r of leg is la ti ve gra ce, an d atax pa y er b ears th e b ur de n of pro vi ng en ti tl em en t t o a ny clai m edde du ct io ns . Rul e 1 42 (a)( 1) ; INDOPC O, In c. v. Co m

m is si on er, 5 03 U.S. at 8 4. Th e ta xp ay er b ears th e b ur de n o f pr ov in g, by a prep on de ran ce o f th e ev id en ce, tha t the de te rm in at io ns of t he Co m m is si on er in a no ti ce o f de fic ie nc y

are i nc orrect . Rul e 1 42 (a); W el chv. Hel ve rin g, 2 90 U.S. at11 5. Fo r cas h m etho d t ax pa y ers , a m ortg ag e in te res t d educ ti on requi res th at
m ortg ag e in te res t b e p ai d i n c as h o r it s equi va le nt . DonE. W il li am s C o. v . Co m m is si on er, 4 29 U.S. 56 9, 5 78 -5 79 (19 77 ); Eck ertv. Bu rn et , 28 3 U.S. 1 40 , 14 1 (1 93 1) ; M en z v . Commis si on er, 8 0 T.C. 1 17 4, 1 18 5 (1 98 3) . A pro mis so ry no te is ge ne ral ly notco ns id eredto be th e equi va le ntof c as h b utm erel y a pr om is e to pa y . Helv eri ng v. Pri ce, 3 09 U.S. 40 9, 4 13 (19 40 ); Na t Harris on Ass oc s., In c. v. Co m m is si on er, 4 2 T.C. 6 01 , 62 4 (1 96 4) . If th e o bl ig at io n t o p ay m ortg ag e in te res t is sat is fie d t hr ou gh th e is su an ce o f no te s t o t he same len de r to who m th e m ortg ag e in te res t i s o wed , th ere h as be enno pa ym en t o f m ortg ag e in te res t; rathe r, paym en t ha s m erel y

be enpo stpo ne d. Dav is on v. Co m m is si on er, 1 07 T.C. 35 , 41 (19 96 ), aff’d, 1 41 F.3d40 3 (2 d C ir. 1 99 8) ; St on e v . Comm is si on er, T.C. Mem o. 1 99 6- 50 7.- 30 -

[* 30 ] Farg o a ndKin g arg ue th atth ey cal cu la te d t he m ortg ag e in te res t u si ng a frac ti on with t he qu al ifi edm ortg ag e d eb t as th e num erat oran d t he ou ts tand in g pr in ci pa l o n t he un de rlyin g l oans as t he de no m in at or . Farg o a ndKin g u se d a n am ountforth e qua li fie d m ortg ag e d eb t tha t was gre at er tha n t he st ip ul at ed
am ount . Add it io na ll y , Farg o a ndKin g d is reg ard edth e im pl ic at io ns of r efi na nc in g a lo anwith t he same len de r. Res po nd en t ar gu es th atFarg o a ndKin g c la im eda la rg er h om e m ortg ag e in te res t d educ ti on on th ei r 20 02 Fo rm 10 40 th anth ey

are en ti tl edto . In 2 00 2 Farg o a ndKin g re fin an cedon e lo anfor $1 ,47 0,0 00 with alo anfor$1 ,59 0,0 00 fro m th e sa m e le nd er. The in crea se inth e lo anam ou ntwas p art ia ll y att rib ut ab le to ne ga ti ve am orti zedin te res t fr om th e fi rs t l oa n. Th e n eg at iv e am orti zedin te res t pa idth ro ug h re fin an ci ng m us t b e d is reg ard edinco m pu ti ng th e al lo wab le de du ct io n. Th e p art ie s s ti pu la te d t ha t Fa rg o a ndKin g a re l im it edto to ta l qua li fie d
m ortg ag e d eb t o f $9 50 ,00 0; th eref or e, th e to ta l am ou ntof i nt eres t p ai d o n t he larg er l oa n m

us t b e ad jus te d a cco rd in gl y . W e ag ree wi th res po nd en t’s d et erm in at io n i n the no ti ce o f de fic ie nc y th at Farg o a ndKin g’s m ortg ag e in te res t s ho ul d b e ad jus te d fr om

$1 41 ,68 1 t o $ 56 ,10 0.- 31 -

[* 31 ] VIII. Deduc ti on forInv es tm en t In te res t In ve stm en t i nt eres t g en eral ly m ean s “ any in te res t * * * whi chis pa idor accrue d o n i nd eb te dn es s p ro pe rly all oc ab le to pro pe rty hel d fo r in ve st m en t.” Se c. 16 3( d) (3 )(A). In ve st m en t i nt eres t ex cl ud es qu al ifi edres id en ce i nt eres t. Sec
. 16 3( d) (3 )(B) (i) . For n on co rp or at e ta xp ay ers , in ve st m en t i nt eres t i s d educ ti bl e on ly to the ex te ntof the tax pa y er’s n etin ve st m en t i nc om e fo r th e ta xabl e y ear. Sec. 1 63 (d )(1 ). Res po nd en t d is al lo wedall of F arg o a ndKin g’s $ 49 ,09 7 i nv es tm en t i nt eres t de du ct io n. Farg o a ndKin g c la im th e in ve st m en t i nt eres t was pa idon th e d eb t se cu redby the ir p rin ci pa l re si de nc e. Farg o a ndKin g a rg ue th ata po rti on of t he lo anpro ceed s was len t t o re la te d e nt it ie s an d i nt eres t i nc om e was earn edon th os e lo an s. Far go an d Ki ng ha ve fai le d t o e st ab li sh th atth ey ha d i nv es tm en t i nc om e ag ai ns t wh ic h t o o ffs etin te res t ex pe ns es th ro ug h a ny con tra ct s, ag reem en ts , pr om is so ry

no te s, o r ot he r ev id en ce o f bo nafid e in ve st m en t ac ti vi ti es . Acco rd in gl y , we agr ee wi th res po nd en t tha t the in ve st m en t i nt eres t d educ ti on sh ou ldbe di sa ll owe d. IX. Accuracy-Rel at edPen al ty Sect io n 6 66 2( a) an d (b )(1 ) an d (2 ) im po se s a 2 0% a ccu racy-rela te d p en al ty if a ny partof a n u nd erp aym en t o f ta x re qu ire d t o b e sh own on a return i s due to ,- 32 -

[* 32 ] am on g o th er thi ng s, n eg li ge nc e o r di sr eg ardof rul es or r eg ul at io ns or a subs tant ia l u nd ers ta te m en t o f in co m e ta x. Th e p en al ty is 2 0% o f th e p orti on of t he
un de rp aym en t o f ta x t o wh ic h t he sec ti on ap pl ie s. Sec . 66 62 (a). The Co m m is si on er b ears th e b ur de n o f pr oduc ti on on th e ap pl ic ab il ity of a n accu racy-rela te d p en al ty in tha t h e m us t co m e fo rwardwith s uf fic ie ntev id en ce in di cat in g tha t i t i s p ro pe r to im po se th e p en al ty. See s ec. 7 49 1( c); see als o Hig be e v . Comm is si on er, 1 16 T.C. 43 8, 4 46 (20 01 ). Once th e Co m m is si on er m eet s thi s b ur de n, the bu rd enof p ro of rem ai ns with t he tax pay er, i nc lu di ng th e bu rd enof p ro vi ng th atth e p en al ty is i napp ro pr ia te be cau se of r eas on ab le cau se an d g oo d fa ith. Se e Hig be e v . Comm is si on er, 1 16 T.C. at 4 46 -4 47
. The Co m m is si on er s at is fie s h is bu rd enof p ro du ct io n b y sh owi ng th atth e un de rs ta te m en t m eet s the de fin it io n o f “ subs tant ia l” . See J an is v. Co m m is si on er, T.C. Mem o. 2 00 4- 11 7, af f’d, 46 1 F .3d10 80 (9t h C ir. 2 00 6) , andaff’d, 4 69 F.3d 25 6 (2 d C ir. 2 00 6) . An und ers ta te m en t o f in co m e ta x i s “ subs tant ia l” if i t ex ceed s th e g reat er o f 10 % of t he tax requi redto be sh own on th e return o r $5 ,00 0. Se c. 66 62 (d )(1 )(A). An “ un de rs ta te m en t” is de fin edas t he ex ces s o f th e ta x re qu ire d t o be sh ownon th e return o ve r th e ta x a ctua ll y sh own on th e return, l es s an y reb at e. Sec. 6 66 2( d) (2 )(A). The un de rs ta te m en t o f in co m e ta x i n d oc ke t No . 28 97 0- 11 is $3 22 ,06 4, wh ic h e xc eed s 1 0% o f th e ta x re qu ire d t o b e sh own on th e return, wh ic h- 33 -

[* 33 ] is gre at er tha n $ 5,0 00 an d i s thu s “ subs tant ia l” . Res po nd en t h as th eref or e m ethi s b ur de n o f pr oduc ti on . The am ountof a n u nd ers ta te m en t s ha ll be reduc edby that p orti on of t he
un de rs ta te m en t wh ic h i s at tri bu tabl e to : (1 ) th e ta x t reat m en t o f an y it em by the ta xp ay er i f th ere i s o r was subs tant ia l au th or ity forsu chtre atm en t o r (2 ) an y it em if t he tax pa y er ad equa te ly dis cl os edrel ev an t fa ct s af fect in g the it em ’s tax tre atm en t i n t he return o r in a st at em en t at ta ch edto th e return a ndth ere i s a reas on ab le ba si s fo r th e ta x t reat m en t o f th e it em by the tax pa y er. Sec
. 66 62 (d )(2 )(B)
. Farg o a ndKin g arg ue th atth e acc ur acy-relate d p en al ty doe s n otap pl y be cau se th ey

m eetth e rea so nabl e cau se de fen se of s ect io n 6 66 4( c)(1 ). Pur su an t t o th atsec ti on , an a ccuracy-rela te d p en al ty und er s ect io n 6 66 2 d oe s n otap pl y to an y po rti onof a n u nd erp aym en t fo r whi cha ta xp ay er es tabl is he s tha t h e o r sh e: (1) ha d re as on ab le cau se an d (2 ) act edingo odfai th . Whe th er a t ax pa y er h as act ed with re as on ab le cau se an d i n g oo d fa ith d ep en ds on th e p ert in en t fa ct s an d ci rcu m st an ces , in cl ud in g e ffo rts to ass es s the pro pe r ta x l iabi li ty, th e ta xp ay er’s kn owl ed ge an d e xp eri en ce, an d t he ex te ntto whi chth e ta xp ay er re li edon th e advi ce o f a t ax pro fes si on al . Sec. 1 .66 64 -4 (b )(1 ), In co m e Tax Reg s. “ Gen eral ly,- 34 -

[* 34 ] th e m os t i m

po rta ntfact oris th e ex te ntof t he tax pa y er’s eff ort t o a ss es s the ta xp ay er’s p ro pe r ta x l iabi li ty.” Id. Altho ug h F arg o a ndKin g c la im to ha ve fol lo wedth e advi ce g iv ento th em by the ir t ax advi se r, th ey

ha ve m ad e n o a tt em

ptto est ab li sh th atth ei r rel ianc e was reas on ab le . See Fre yta g v . Comm is si on er, 8 9 T.C. 8 49 , 88 8 (1 98 7) , aff’d o n an ot he r is su e, 90 4 F .2d10 11 (5t h C ir. 1 99 0) , aff’d, 5 01 U.S. 86 8 (1 99 1) ; se c.1 .66 64 -4 (b )(1 ), In co m e Tax Reg s. We hav e p rev io us ly hel d tha t fo r a t ax pa y er t o re ly reaso nabl y up on advi ce s o a s p os si bl y to ne ga te a se ct io n 6 66 2( a) ac cu racy-rela te d p en al ty det erm in edby the Co m m is si on er, the tax pa y er m us t p ro ve * * * tha t the tax pa y er m eet s each requi rem en t o f th e fo ll owi ng th ree- pr on g t es t: (1) The a dv is er was a co m

pe te ntpro fes si on al who ha d s uf fic ie ntexpe rti se to jus ti fy rel ianc e, (2 ) th e ta xp ay er p ro vi de d n eces sa ry an d a ccu rat e in fo rm at io n t o t he advi se r, an d (3 ) th e ta xp ay er ac tu al ly reli edingo od fai th on th e advi se r’s jud gm en t. Neo na to lo gy Asso cs ., P.A. v. Co m m is si on er, 1 15 T.C. 43 , 99 (20 00 ), aff’d, 2 99 F.3 d 2 21 (3dCir . 20 02 ). Farg o a ndKin g h av e fai le d t o p ro ve th atth ey sat is fie d
an y of t he se th ree r equi rem en ts . Farg o a ndKin g h av e fai le d t o p ro ve th ey m eetth e rea so nabl e cau se de fen se of sec ti on 66 64 (c)( 1) . As a res ul t, we h ol d the m li ab le forth e 2 0% a ccu racyrel at edpe na lty .- 35 -

[* 35 ] To re fle ctth e fo reg oi ng , Deci si on s wi ll be en te redun de r Ru le 15 5.